American Superconductor Corporation: A Great Short-Term And Long-Term Opportunity
Summary
- Since more than tripling starting in early 2018, AMSC’s stock has declined about 50%, with no change in the future prospects.
- REG is looking to disrupt legacy power grid designs and approaches, while SPS is looking to disrupt legacy copper-based mine countermeasure systems aboard Naval vessels.
- The initial commercial orders for both products in late 2018 that contributed to the stock surge validate the opportunity.
- The balance sheet is adequate now that the Sinovel settlement payment has been received, putting that chapter of the company’s history behind us.
- Our best-case scenario PT is $18.49/share, which offers 158% upside.
Investment Thesis Summary
American Superconductor Corporation's (NASDAQ:AMSC) stock more than tripled starting in early 2018, on the expectation (and eventually the respective announcements) of the company's first commercial orders for disruptive new products Resilient Electric Grid ("REG") and Ship Protection Systems ("SPS"). Since climbing above $15.00/share, it has since declined about 50% due to general market fatigue. This is no longer the same company whose Wind segment got crushed by the loss of major customer Sinovel ten years ago. The Grid segment, driven by its two main products targeting the US Navy and electric utilities, is poised for very strong growth. Our best-case scenario PT is $18.49/share, which offers 158% upside. We think AMSC is a Strong Buy.
The (Distant) Story
AMSC: 10-Yr Stock Chart
Source: Seeking Alpha
On November 1, 2010, American Superconductor Corporation closed at just below $370/share and sported a market cap in the billions. Out of the blue, its primary customer, Chinese wind giant Sinovel Wind Group, announced that they would no longer be accepting shipments of wind turbine components from AMSC. Eventually, it came to light that a former AMSC engineer had stolen some intellectual property ("IP") that Sinovel was now using to produce its own components. By the end of 2011, AMSC was trading under $40/share and had become the poster child for American companies complaining of IP theft at the hands of the Chinese. They were even featured on an episode of CBS's 60 Minutes, titled "The Great Brain Robbery," which aired on January 17, 2016.
After years of legal disputes which spanned across America, China, and the EU, AMSC and Sinovel finally settled all of their existing commercial disputes on July 3, 2018, for the sum of $58M - an absolute pittance, considering AMSC's losses had exceeded $500M. At this point, however, the Sinovel chapter of the company's history is fully behind us, and a new investor looking at the company's 10-yr stock chart should know that AMSC today is a very different company.
The (More Recent) Story
AMSC: 5-Yr Stock Chart
Source: Seeking Alpha
The stock dropped a bit on the Sinovel settlement news, though not as much as might have been expected, likely because investors understood that AMSC had minimal legal recourse to recoup losses inside of China. But we saw an opportunity and recommended buying AMSC in anticipation that, after several years of testing, the first ever commercial order of their REG system would be announced.
Indeed, on October 31, 2018, AMSC announced the first-ever commercial REG order, placed by Chicago utility Commonwealth Edison Company ("ComEd"), a unit of Chicago-based Exelon Corporation (NASDAQ:EXC). This long-awaited news, along with positive developments in the business with the Navy, pushed the stock up to just over $15.00/share in early 2019. We recommended exiting, locking in a gain just shy of 180% on our recommendation.
Why is the stock mispriced?
In the months that followed, the stock gradually declined about 50%, with no material change in the story. We attribute the decrease in price to "Market Fatigue", a term which describes a protracted lack of attention to and enthusiasm for a stock in absence of news and/or perceived catalysts. Market fatigue is often the cause of slow but extended down drifts when there is no new information to justify a change in investors' expectations.
In the specific case of AMSC, many investors likely wanted to protect gains (as we did) after the stock had performed so strongly - with many investors that got in during 2018 seeing up to a tripling of their investment. As positions were closed or lightened, attention and capital were shifted elsewhere, pushing the stock down further and likely triggering more selling from investors looking to protect their gains.
As is true always, the price of a stock depends on demand and supply. ASMC is not a well-known stock and has a limited pool of investors that follow it in a semi-active way. With this group's attention diverted away, there was nothing (i.e. no news) to build up demand.
Finally, a bearish article from White Diamond Research, published on Seeking Alpha on March 25, 2019, likely also played a part in the stock declining. We discuss in detail several of the bearish arguments they put forth in the "Risks" section towards the end of this article. But the general crux of their article is that AMSC's stock price rise was due to unjustified hype generated from "puffy press releases" regarding the REG and SPS businesses - businesses which they think are still in the trial stage, impractical, and not something that the government will spend a significant amount of funding to support.
This lack of belief by other investors in the long-term prospects of these two Grid products is central to why we think the stock is mispriced. We agree that, without REG and SPS sales ramping up, there is no hope for AMSC ever reaching profitability. But, as we outline in the remainder of the article, we think the current evidence supports concluding that REG and SPS are ready to move decisively from the R&D phase to the commercial phase, have concrete benefits over the legacy products they are looking to replace, and are products that the government is willing to support significantly. It is for these reasons that we think the stock mispricing is unjustified. In our view, there has been no material change in the long-term prospects of REG and SPS, and we remain very bullish on both.
What makes this investment actionable?
We view the stock's prior upward reaction as validating the budding commercial prospects of both new Grid products, and showing that this investment is actionable.
Our thesis is that, after almost a decade of trading sideways due to the Sinovel fiasco, there is reason to think that AMSC's stock is ready for a sustained move upwards, this time driven by the Grid segment. There are some new markets that AMSC is trying to enter. And if things play out successfully, the windfall (no pun intended) could be sizable.
Overview
The company has two reportable operating segments: Grid and Wind.
Wind Segment
Through its Wind segment, AMSC offers an array of advanced power electronics and software-based electrical control system ("ECS") products used in wind turbines, licenses its wind turbine designs, and provides customer support services to wind turbine manufacturers.
Considering the steady growth of global wind energy projects over the past 10 years, it would seem that this should have been a strong tailwind for this segment. But, as you can see below, the Wind segment took a big hit from the loss of Sinovel in FY2010 and has been unable to generate any meaningful new business since then. (Note: The $48M operating income for the Wind segment in FY2018 is largely due to the one-time Sinovel settlement payment).
Segment Revenues And Operating Income (FY2009-FY2018)
Source: Elle Investments, Company filings
Their largest Wind customers at this point are Inox Wind in India (34% of total FY19 revenues) and Doosan Heavy Industries in Korea (less than 10% of total FY19 revenues). Both are hoping to expand into new wind projects in their respective territories, which could provide a surprise boost to AMSC's Wind revenues. But, given the lackluster historical performance of this segment, we do not have high hopes for a meaningful improvement in the Wind segment financials. Our optimism lies exclusively with the Grid segment.
Grid Segment
Through its Grid segment, AMSC targets the needs of electric utilities, industrial facilities, and renewable energy project developers (i.e. solar and wind farms). Their Grid products help these large-scale customers connect, transmit, and distribute power across the electric grid. The segment also sells ship protection products to the U.S. Navy. While they have a host of innovative products in this segment, our focus will be on the two where we see the most potential: REG and SPS.
REG
There is much discussion regarding the need to modernize electricity grids (that were built generations ago) so that they are able to better deal with the challenges we face today (see the Department of Energy's "Vision Of The Future Grid" page). These challenges include more frequent severe weather events, rogue physical- and cyber-attacks, the taxing demands caused by the ebb and flow of intermittent renewable energy generation, and new types of customer loads (i.e. electric vehicles ("EV")).
One persistent problem, in particular, is the massive social and economic disruption that is caused when power is knocked out in a specific part of a city. Businesses and residents must sometimes wait for several days for work crews to get around to their neighborhood and restore power. This problem could have been avoided if, as the electric grid was developed, all new substations in a city were connected to an existing substation so that, when power in one substation went out, another substation could immediately begin to feed power in to the substation that is down. However, when the electric grid was developed, it would have been prohibitively expensive to connect all substations in such a manner, given the cost of heavy copper wire.
AMSC's engineering expertise is built on several decades of research into high temperature superconductors ("HTS"), which started off as being extremely expensive to manufacture but whose production costs have come down significantly. Superconductors are materials that exhibit certain physical properties-namely, the property of vanishing electrical resistance. Whereas all normal conducting materials exert some resistance to the passage of electricity, a superconducting material does not impede the flow of current at all and, thus, is able to more efficiently carry an electrical load.
In the image below, the thin coiled band is AMSC's Amperium HTS wire. It is wrapped around a copper bundle with an equivalent current carrying capacity. Depending on the wire material (brass, copper, or stainless steel), Amperium HTS wire can conduct up to 200 times the electrical current of an equivalently sized copper wire.
AMSC's Amperium HTS Wire vs Equivalent Copper Bundle
Source: Company website
The benefits of HTS cable with respect to modernizing the electric grid should now seem readily apparent. AMSC's REG solutions (which make use of Amperium HTS wire) now offer the capability to interconnect all existing power substations at a fraction of the cost (and space) compared with traditional copper wire.
The Value Proposition Of REG
Source: November 11, 2019 presentation (slide 14)
On the 2Q16 earnings call, management laid out the commercial opportunity for REG, and it is quite large.
". . . If you think about REG I mean REG is tens of millions of dollars solution regardless of what you do, right. So there is no hundreds of thousand dollar order for REG. When we even talk about smaller systems, they are in - they probably start at $20 million, $25 million and they go up to - what we are learning is $250 million, $400 million depending upon the scope . . ."
Investors that took a position in AMSC after the stock price collapsed in 2011 were most likely influenced by the potential of the company's REG solutions. It had been a long wait, as the testing phase took 4 years from the time it was announced on July 16, 2014. But, finally, on October 31, 2018, AMSC announced its first-ever REG commercial order. The order, for an amount between $9M and $11M over the course of the contract, was from Chicago's ComEd utility, and includes $1M that AMSC has agreed to reimburse ComEd for the installation, as well as cost sharing with the Department of Homeland Security ("DHS"). The REG system is expected to be operational by early 2021.
While this first contract was for only about $10M, the market pushed the stock up significantly because it served as a validation that REG was finally ready to go to market.
On the recent 3Q19 earnings call, management again discussed a second potential project in Chicago. This proposed project would link multiple substations in the city and would be on the order of 4 to 6 times larger than the current project. Discussions remain ongoing, but this would further validate the scale of the commercial opportunity.
Chicago REG Projects
Source: November 11, 2019 presentation (slide 17)
Below, you can see the cities where REG studies are taking place. Again, it did take 4 years from the time the first Chicago study was announced to the time the commercial order was placed. Going forward, the transition from testing to implementation will likely smooth out, as the lessons learned along the way are applied in future projects (the company even mentions this on slide 17 of the November 2019 presentation above).
REG Studies
Source: Elle Investments, Press releases
Still, even though the adoption of REG systems across the US will be slow, what's important to keep in mind is the size of the opportunity. Some quick back-of-the-envelope calculations based on the biggest 15-20 US cities adopting this show that the revenues could be sizable for a company with a market cap of under $200M.
REG Benefits And Testing Sites
Source: November 11, 2019 presentation (slide 16)
Ship Protection Systems
The other promising product in AMSC's Grid segment is HTS-based SPS. (Note: AMSC refers to its HTS-based suite of products for the US Navy as SPS. Down the road, there could be several applications for SPS (i.e. power, propulsion, weaponry, etc.), but to start, our discussion will focus solely on the ship degaussing application, which is the first application of SPS to receive a contracted order.)
All steel-hulled ships act like large floating magnets as they move through the water, interacting with and distorting the Earth's magnetic field. This unique magnetic field that each ship creates is called the ship's signature and can be detected by and trigger naval mines.
(Degaussing is the process by which a ship's magnetic field is reduced or eliminated altogether. Allied forces spent a great deal of effort during WWII trying to counter German magnetic naval mines that were activated by a passing ship's magnetic field.)
How Degaussing Works
Source: November 11, 2019 presentation (slide 29)
Though the techniques developed to avoid mine detection have proved more or less successful, the large weight and cost of degaussing systems (which often involve wrapping a large metallic copper coil around the hull) have long had a negative impact on a ship's speed and power consumption.
Over the last several years, AMSC and the Navy have been developing HTS Degaussing Cables. The HTS-based system reduces legacy degaussing system weight by as much as 50% and offers a considerable amount of savings in system power usage.
HTS Degaussing Cables vs Copper Degaussing Cables
Source: November 11, 2019 presentation (slide 30)
On the Q4 2015 earnings call, management provided some potential pricing details for SPS depending on the ship size. For smaller ships like the Littoral Combat Ship ("LCS"), potential revenue would range from $3M to $5M. For medium-sized ships like Destroyers or Amphibious Assault ships, the revenue might range from $5M to $15M per ship. And for larger ships such as aircraft carriers, the range goes from $20M to $25M.
Estimated SPS Revenue Per Ship
Source: 4Q15 earnings call, Naval Vessel Register
As of February 14, the Naval Vessel Register was showing the active fleet size to be 250 ships. Since SPS can be retrofitted into existing ships (also discussed on the 4Q15 earnings call), the potential opportunity fleet-wide is fairly large.
However, the really "sticky" opportunity lies in SPS being incorporated into the baseline design of new ships. This opportunity was validated on November 28, 2018, when AMSC announced that SPS had been chosen as the baseline design for the USS San Antonio-class amphibious assault vessels. At about $10M per ship, this essentially provides an annuity-like revenue stream for the next few years as new ships roll off the production line into active service.
USS San Antonio-Class Vessels Revenue Opportunity
Source: November 11, 2019 presentation (slide 31)
Long term, whether the Navy actually expands its fleet to 355 ships remains to be seen. But any growth in the size of the fleet would be a plus for AMSC, as it increases the chances of having SPS worked into the baseline design of new vessels.
Part of what contributed to the recent jump after the 3QFY19 earnings call was management's comments regarding future SPS plans. The Navy has identified the next class of ship that SPS will be deployed on, and while details were not disclosed yet, AMSC continues to pursue additional classes of vessels with the Navy and believes it's in a position to get additional SPS orders in the future. The evidence indicates that, after years of collaboration and testing between AMSC and the Navy, SPS is also ready for widespread market adoption.
And it's important to keep in mind that HTS-based SPS can be used for other naval applications than just degaussing.
On March 3, 2003, AMSC announced that it had won a multi-year, $70M U.S. Navy contract to, in cooperation with shipbuilder Northrop Grumman (NOC), "optimize the design, integration and testing of the HTS (high temperature superconductor) propulsion motor for integration into electric warships." The press release includes a very forward-looking statement from Rear Admiral Jay M. Cohen, the former Chief of Naval Research:
"The U.S. Navy is going electric. Superconductor technology will help reduce the size and weight of motors, generators, power transmission and supporting electrical components to help speed the transition to electric this decade. This contract is an important step along the road to attaining these capabilities."
As is common with most new military hardware platforms (see the F-35), the transition often ends up over budget and behind schedule. The move to an "all-electric" Navy did not happen as quickly as planned, but it's starting to take form.
On July 31, 2013, IEEE Spectrum magazine published an informative piece on the USS Zumwalt, the lead ship of the new Zumwalt destroyer-class. The USS Zumwalt was not commissioned into active service until October 15, 2016, but the piece in IEEE Spectrum did a good job of explaining the key selling points of the Navy's most technologically advanced warship to date.
In addition to its stealth design and wave-piercing hull, the Zumwalt-class also sports a state-of-the-art electronic propulsion system. What is interesting about the Zumwalt's design is that the gas-turbine engines are not connected directly to the two electric motors. Instead, generated electricity flows between them throughout the ship's network, which allows for more flexibility in delivering power to where it is needed.
The design of "electric warships" like the Zumwalt-class destroyers would allow for future high-energy weapons or computing systems, such as an electromagnetic railgun, to be integrated seamlessly. Considering uses such as this, it's easy to see why AMSC management continues to mention that there exists additional SPS applications apart from ship degaussing - specifically in power, propulsion, and protection equipment (though there is no timetable for when a commercial order might be received).
As an added bonus, AMSC could sell its SPS product to any number of countries that make up the Allied Navy. Talks with friendly international partners are ongoing, but no orders have been announced yet.
We think the move towards a more "electric" US Navy is irreversible, and this should serve as a very strong tailwind for AMSC's SPS product offering.
D-VAR And D-VAR VVO
Apart from REG and SPS, AMSC also has two other intriguing products in its Grid segment.
The D-VAR system consists of power electronics and additional static components that are used for controlling power flow and voltage in an AC transmission system. Power that flows through AC networks is made up of both real power (measured in watts), and reactive power, which is measured in Volt Amp Reactive ("VARs"). Basically, reactive power is needed as a support for voltage across power networks. The purpose of AMSC's D-VAR product offering is to provide the reactive power that can act to stabilize voltage across the grid. This can be especially important at the point where solar and wind farms are connected to the grid, or to protect industrial facilities from sporadic voltage surges and drops.
D-VAR Market Opportunities
Source: November 11, 2019 presentation (slide 12)
D-VAR VVO (Volt Var Optimization) is also designed to optimally control voltage, given the growing impact of distributed energy generation, such as from roof top and community solar. AMSC believes that VVO has the potential to save utilities both time and money by avoiding costlier options that are needed to increase the reliability and resiliency of the grid. The targeted markets of VVO include electric distribution grids that are dealing with mass adoption of rooftop and/or community solar.
D-VAR VVO Market Opportunities
Source: November 11, 2019 presentation (slide 13)
Both D-VAR products face intense competition, and so it's not clear at this time that they will be able to stand out in a crowded field. Still, given the changing nature of energy production (i.e. wind and solar) and demand (i.e. electric vehicles), the D-VAR and D-VAR VVO product lines should provide a modest but consistent contribution to future revenues.
Valuation (Management Scenarios)
Best-case PT: $9.32/share
Best-case upside: 30%
We have modeled two sets of scenarios: one "near-term" based on management's projections, and one "long-term" based on our projections. To arrive at our price targets given management's scenarios, we have made the assumptions below.
Revenue: $100M - $250M
As you can see in the slide below, AMSC management has provided us with some possible revenue scenarios depending on how many megawatts ("MW") of ECS are procured, how many ship platforms adopt SPS, the ultimate size of the aggregate initial REG installation, and some minor variability for D-VAR and D-VAR VVO products. We consider these scenarios provided by management to be "near term."
Management Scenarios
Source: November 11, 2019 presentation (slide 37)
Gross margin: 26% - 31%
See slide above.
Cash OpEx: $28M - $34M (14% - 28% of revenue)
See slide above.
Depreciation and amortization (as a % of revenue): 7.5%
For the 9 months ended December 31, 2019, depreciation and amortization ("D&A") expense was $3.3M (this is slightly above the $3M spent over this same period on capex). Revenues during this period were $45.7M, which works out to a D&A expense of 7.2% of revenue.
For the 9 months ended December 31, 2018, D&A expense was $3.5M and revenue was $41.6M. This works out to a D&A expense of 8.4% of revenue.
For our modeling, we have assumed that D&A expense will be 7.5% of revenue going forward.
Interest expense: $0M
AMSC has no debt.
Tax rate: 10%
As of March 31, 2019, AMSC had aggregate federal and state net operating loss carryforwards ("NOLs") in the US of $776M and $198M, respectively (FY18 10-K, pg 60). These NOLs will be utilized to offset a significant portion of future income tax.
For the 3 months ended December 31, 2018, AMSC paid income tax of $1.6M on pretax income of $18.9M. This equates to a tax rate of about 8.5%. For the 9 months ended December 31, 2018, AMSC paid income tax of $4.5M on pretax income of $39.7M. This equates to a tax rate of 11.3%. (Note: AMSC had a pretax loss for the 3 and 9 months ended December 31, 2019, and so we have used the 2018 figures to arrive at our expected tax rate.)
For our model, we will assume a tax rate of 10% going forward.
Target P/E: 10x
We remind investors that the inverse of the P/E is the earnings yield, E/P. As standard practice, for healthy (non-biotech) companies in steady mode we usually assume a required rate of return of 10%, which equates to a P/E of 10x. This seems like a very reasonable P/E that the market would assign once it becomes clear that AMSC's REG and SPS products will see widespread adoption in their respective target markets.
Fully diluted share count: 22.7M
As of January 31, 2020, AMSC had an outstanding share count of 22.6M (3QFY19 10-Q, pg 1). On page 12 of the same 10-Q, it is mentioned that, for the 3 months ended December 31, 2019, 0.1M options were not included in the computation of earnings per share, as their effect would have been anti-dilutive. To be conservative, we have simply included all anti-dilutive options in the fully diluted share count and have not looked into their average exercise price to gauge their likelihood of being exercised.
Fully diluted market cap: $163M
We used the intraday price of $7.16/share on March 2 and a fully diluted share count of 22.7M to calculate the fully diluted market cap.
Fully Diluted Market Cap
Source: Elle Investments, Yahoo Finance, Company filings
Price Targets Under Management's Near-Term Scenarios
Source: Elle Investments
Valuation (Elle Investments Scenarios)
Best-case PT: $18.49/share
Best-case upside: 158%
We consider our projections to be more "long-term" estimates when compared with management's scenarios. To arrive at our price targets, we have made the assumptions below.
REG Revenue: $150M - $300M
Obviously, the immense time and capital that went into developing REG were not invested simply to have only one city make use of it (as is assumed in management's scenarios). We see the technology being adopted by several major metro areas across the US. Because of this assumption, our long-term scenarios consider multiple REG installations per year.
We have assumed $50M per REG installation. This is the midpoint of the $25M to $75M range that management gave on the 2QFY18 earnings call. This range was for projects that could be executed in one year, and amounted to a $500M+ opportunity (in the US) for the current funnel of about a dozen projects spread across many utilities.
Keep in mind that the total annual addressable market in the US (assuming all urban substations in major metro areas are connected with REG systems) is from $1B to $2B (FY17 10-K, pg 7).
SPS Revenue: $60M - $90M
Just as with REG, the time and capital that went into developing SPS was not to simply have it being used on a small handful of vessels. The end goal is to have it adopted across the US Navy's fleet, as well as across the Allied Navy.
We have continued to use an amount of $10M per ship (as a reminder, this amount is only for the initial application of degaussing and ignores other potential uses).
Keep in mind that management believes the total addressable market for HTS-based SPS for the marine market is from $70M to $120M per year for the years 2020 through 2025.
Other Grid revenue: $25M
This assumption includes Grid revenue that will come from the D-VAR and D-VAR VVO line of products.
Through the first 9 months of FY19 (which ends March 31, 2020), AMSC announced a total of $41M in D-VAR orders: $10M announced on April 9, 2019, $20M announced on November 19, 2019, and $11M announced on December 19, 2019. This momentum in D-VAR orders continues to be driven mainly by strong demand from the renewable energy sector and also, to a lesser extent, industrial customers. While revenue from this channel is not broken out, the comments on the 3QFY19 call indicate that AMSC expects to enter FY20 with a strong backlog of D-VAR orders.
But, as we have discussed previously, there is strong competition in these markets. At this time, it's not clear AMSC's D-VAR and D-VAR VVO solutions will be able to differentiate themselves enough in a crowded field in order to grow revenue substantially.
Because the commercial opportunity here does not seem as compelling as with REG and SPS, we assume $25M in revenue from these business lines going forward.
Wind revenue: $10M
For Wind revenue, we assume an amount of $10M. This is much less than the $22M realized in FY18, but is on par with the $9M seen through the first 9 months of FY19. Again, this segment is not material to our investment thesis.
Gross margin: 30%
A gross margin assumption of 30% is consistent with management's best-case near-term scenario, which is at the lower end of our long-term scenarios.
Cash OpEx: $34M - $49M (12% - 14% of revenue)
Cash OpEx of 12% to 14% of revenue is consistent with management's best-case near-term scenario, which is at the lower end of our long-term scenarios.
Depreciation and amortization (as a % of revenue): 7.5%
See Management Scenarios discussion.
Interest expense: $0M
See Management Scenarios discussion.
Tax rate: 10%
See Management Scenarios discussion.
Target P/E: 10x
See Management Scenarios discussion.
Fully diluted share count: 22.7M
See Management Scenarios discussion.
Fully diluted market cap: $163M
See Management Scenarios discussion.
Price Targets Under Elle Investment's Long-Term Scenarios
Source: Elle Investments
Timeframe
Our timeframe for reaching the PT based on the near-term management scenarios is 6 months to 1 year. We expect that, in under 1 year, there will be a final decision made on the second Chicago REG project (and possibly REG news from another city) as well as the Navy's announcement of the second class of ship to deploy SPS. Such news would certainly push the stock up.
Our timeframe for the business to reach our long-term scenarios is several years. As we have discussed previously, it appears it will take a bit of time for a city to go from the REG testing phase to the commercial phase. However, the stock price need not wait for each future REG order to be announced in order to price in REG growth. Once it becomes clear that REG will be deployed in all major urban areas, the stock price will reflect this. The same is true of SPS adoption across many vessel classes. Confirmation that the second, larger REG project in Chicago will move forward might just be enough of a catalyst to propel the stock up over 100%, just as the initial REG order served as the catalyst the last time around.
Risks
Risk #1: Liquidity
Guidance for 4QFY19 says that, as of March 31, 2020, cash, cash equivalents, marketable securities and restricted cash should be no less than $61M, with operating cash flow expected to be a burn of between $2M and $4M. Capex spending is running relatively low (it totaled $3M for the 9 months ended December 31, 2019), so it seems that the quarterly cash burn will continue to hover around $5M per quarter in the near future.
Given the current cash balance and expected cash burn, we see the risk of dilution as being low. Should we see a big jump in the share price, a public offering might make sense, but it would be at a much higher stock price, so it would not have such a negative effect on current shareholders.
Risk #2: Government Bodies Will Stop Supporting REG Deployment
Although the utility companies benefit from REG, they are not the main beneficiaries (the public and public safety are). Therefore, it is likely that utilities will not purchase REG without government support. This support can take form in many ways, such as direct investment contributions, or allowing the utilities to recover the costs of REG implementation through transmission rates.
So far, the government has shown its willingness to use both methods.
First, DHS has so far committed to spending $10M (the amount of revenue AMSC will recognize for this first Chicago project) on the first-ever commercial installation of REG. Should the second project be approved, DHS's commitment would likely be much higher, considering the project is expected to be 4 to 6 times larger than the first (the engineering assessment for the second project was announced on October 22, 2019, but no agreement has been reached yet).
Second, the Federal Energy Regulatory Commission ("FERC") has shown its willingness to use its regulatory authority to support REG. This agency is responsible for regulating the transmission and sale of electricity, and when a utility wishes to recoup all or a portion of certain project costs that they have incurred through the rates they charge customers, they must seek approval from FERC. On May 28, 2019, FERC issued a ruling which granted ComEd's request to recover its portion of the first and second REG projects through its transmission rates.
(Note: The attached FERC ruling can be viewed here: If you would like to view the FERC ruling directly on the FERC website, to do an Advanced Search for the FERC ruling use this link. To perform the search, only check "Issuance" for the Category, uncheck all Date boxes, only select "Electric" for the Library, enter "American Superconductor" in the Text Search box, and select "Description" and "Full Text." Then click "Submit." Look for the search result with a filed date of 5/28/19 and a Docket Number of ER19-1478-000. Then select "FERC Generated PDF" to view.)
As you can see on page 2 of the FERC filing, DHS and AMSC are expected to cover about 53% of the total costs, with ComEd covering the remaining 47%, which is estimated to be about $67M. This ruling significantly de-risks the commercial roll-out of REG, because it shows that FERC was willing to allow ComEd to essentially cover half of the cost of both REG projects through transmission rates.
This decision should serve as a catalyst for other utilities that were on the fence about moving forward with REG, as it now provides a precedent for recouping REG costs through transmission rates. This is something management discussed specifically on the 3QFY19 earnings call, in response to an analyst question about how conversations with utilities have changed since the ruling:
". . . The FERC ruling really has expedited kind of the feeling throughout the organization that recovery is not only possible but certain."
The risk still remains that DHS may not cover half (or any portion) of all future REG projects, as this would amount to a sizable investment from the federal government. But we think the risk of DHS backing out altogether is low, given the support for this technology from many corners. The FERC ruling even mentions (on page 9) that, while ComEd is investing $67M in a technology that has not yet been proven in commercial applications, it "nonetheless holds tremendous promise for the future of urban transmission grids (and a technology that Congress has expressly directed the Commission to encourage)."
A major infrastructure spending bill would clearly be a boon for both utilities nationwide and companies like AMSC that are focused on modernizing the antiquated electric grid. But, given the partisan gridlock in Congress, we do not think it's likely that an agreement over how to fund it will be reached anytime soon. But the good news from Chicago serves to show that utilities can proceed with and recover a substantial portion of REG's costs on their own without the need for federal stimulus to fully fund REG projects.
Risk #3: New Mine Countermeasure Technology Is Not A Priority For The Navy
The bearish article from White Diamond Research (that we reference at the beginning of this article) makes the point that ocean mines have not been an issue since WWII and that it's simply not a priority for the Navy to invest in new mine countermeasure technology right now, given that the US is currently not engaged in a major war.
While we don't dispute the fact that sea mines are not a current problem compared to the damage they inflicted during the second World War, this does not mean that SPS will not see widespread adoption.
Naval vessels are not kept in a less-than-optimal status simply because there is no current threat. The Navy's fleet has been continuously upgraded over the past few decades, even though there has been no large-scale conflict at sea since WWII.
The advantages in terms of SPS's reduced weight and power usage are undeniable. Defense modernization is glacially slow, but it gets there eventually. There is no reason to continue using legacy copper degaussing systems when a more modern alternative is available. The baseline design win for the San Antonio-class (and the expected second class of ship to be announced in the near future) validate this line of thinking.
We acknowledge that the adoption will be slow, but it seems likely to happen.
Risk #4: Competition
As we have previously discussed, competition in the markets that D-VAR, D-VAR VVO, and the Wind segment products compete in is strong. This being the case, we do not feel comfortable assuming significant revenue growth for these business lines and have thus kept our revenue assumptions modest.
With respect to REG and SPS, however, we feel that the value proposition of each is compelling.
At this point, SPS is really just competing with heavier and less efficient legacy copper degaussing systems. For the time being, they are essentially a sole source supplier of SPS, as they continue to say that: "We believe we are currently the only company that can offer HTS-based SPS products that have been fully qualified for use aboard U.S. Navy surface combatants (FY18 10K, pg 10)." The moat for SPS seems wide.
The moat for REG also seems wide, given AMSC's new approach to power grid design. REG essentially competes with legacy approaches that involve new substation construction, cumbersome copper-bundle based transmission lines, and underground transformers.
What investors should take away from this is that REG and SPS are not "MeToo" products - they are new, unique, and disruptive in their respective markets.
The IP portfolio of AMSC is not discussed much on their earnings calls. This leads us to believe that their value proposition lies more in their engineering expertise and the implementation of superconductors into real-world applications.
As we discuss in Risk #6, there are other companies that manufacture HTS cable. However, they seem to have a head start in the implementation of HTS-based REG solutions, and for the time being, they look like the sole supplier for HTS-based mine countermeasure systems.
It's worth mentioning that the bearish article from White Diamond Research also points out that there are alternatives to AMSC's product, and mentions that the Navy tested another HTS degaussing coil system in April 2009. We tracked down this Office of Naval Research ("ONR") press release from 2009, and one of the partners involved was in fact AMSC (among others). This shows that the company has been there every step of the way through HTS-based degaussing development, and at the moment, it does not look like there are other alternatives besides legacy copper degaussing systems.
Risk #5: The Lag Time Between Testing And Contract Announcement Is Long, And The Stock May Drift For A While
This is a valid concern, for REG especially. As we have previously discussed, it took 4 years from the time the REG testing initiation announcement was made to the order being placed. Future testing will likely speed up as AMSC incorporates the lessons learned from previous projects, but this lag time may still be considerable.
What investors should keep in mind is that the full REG revenue for each installation does not have to be confirmed in order for the stock price to react.
As the move in the stock price in late 2018 showed, one modest $10M REG order and one baseline design win for one class of Naval vessel were enough to cause the stock to soar. Stock prices are always forward-looking, and we are confident that as AMSC's REG and SPS technologies continue to be validated through a growing number of commercial orders, the stock price will move so as to factor in future growth opportunities.
Risk #6: Superconductor Technology Is Not Yet Ready For AMSC's Intended Applications
Another company we follow is Superconductor Technologies (OTCQB:SCON). Their website does a compelling job explaining the potential of superconductor technology and some of its exciting applications, such as fusion power, energy storage, high-field magnets (such as those used in MRI machines), and fault current limiters.
But SCON has not yet been able to successfully transition from the R&D phase to the commercialization phase. Revenue for 3Q19, all of which came from a Department of Energy ("DOE") project, was only $157K.
It's still early in the process, and all parties are aware that there remain unforeseen risks that could arise with high-temperature superconductors - namely, that HTS cables require complicated cooling systems that continuously bathe the cables in liquid nitrogen (see page 13 of the FERC ruling).
But, unlike with SCON, the potential HTS commercial opportunity that AMSC has been working on for the past several years has been initially validated by two large customers: the Navy and an electric utility. And all signs point to growth from both customer channels.
Risk #7: Other General Risks
There are some other points made in the recent bearish articles on Seeking Alpha, such as excessive management compensation and the company's lack of profitability. We do not feel they merit lengthy and individual rebuttals.
Plenty of companies spend years generating losses before their sales finally take off, with management paid handsomely along the way. Ideally, a larger percentage of executive compensation should be tied to company and stock performance, as this would offer more of an aligned interest with shareholders. But this is not a critique that is unique to AMSC and is simply the nature of investing in the stock market: management is guaranteed a paycheck, but you as an investor are not guaranteed a company that will eventually make money, nor a stock that will eventually go up.
At this point, however, the persistent losses and excessive compensation are sunk costs, and we are not investing in the past. What matters is the future, and we have modeled future scenarios which we think are realistic and that show upside for investors placing their bets now. And if anything, new investors should be thankful for the ten years of persistent losses, as the NOLs they helped generate will be used to offset future taxes, and thus increase returns to the bottom line.
If, at this point in time, you are bothered by AMSC's executive compensation and persistent losses, then you also would have been bothered by them in late 2018 - and you would have missed out on the stock going up almost 180%.
Conclusion
The interesting thing about investing is that two opposing viewpoints can both be right about the same stock. We guessed right in 2018 that the first-ever REG order would push the stock up, and bears also guessed right that the stock would deflate and drift back down. But this decline does not invalidate our long-term bullish thesis, since no stock ever goes up or down in a linear fashion.
We see AMSC as both a long-term hold with short-term potential as well. While the company is positioning itself for years of quiet but steady growth, there is the additional possibility that good news will propel the stock up again for a 100% gain, just as it did before.
Accordingly, we intend to hold part of the position for the long term while another part will be a variable holding on which to realize gains if the stock rises "ahead of itself" in a relatively short time-frame (like it did before).
The gradual descent back down from $15.00/share has created a mispricing opportunity. AMSC spent years trading sideways as the market waited for the testing and development of their new Grid products, REG and SPS, to be completed. Commercial orders for both products received during 2H18 sent the stock price flying, validating the future market opportunity. Long-time investors understand the cards AMSC holds and understand that the reaction to these two products finally making it to market was not a fluke. Our best-case scenario PT is $18.49/share, offering 158% upside. We think AMSC is a Strong Buy.
Glossary
AC: alternating current
D&A: depreciation and amortization
DHS: Department of Homeland Security
DOE: Department of Energy
ECS: electrical control system
EV: electric vehicles
IEEE: Institute of Electrical and Electronics Engineers
IP: intellectual property
LCS: Littoral Combat Ship
MW: megawatt
NOL: net operating loss
ONR: Office of Naval Research
PT: price target
REG: Resilient Electric Grid
SPS: Ship Protection System
VVO: Volt Var Optimization
WASO: weighted average shares outstanding
This article was written by
Analyst’s Disclosure: I am/we are long AMSC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Disclaimer: The Elle Investments portfolio is managed utilizing a “quantamental” approach where each position, while based on Fundamental Analysis, is sized as part of a larger quantitative portfolio. The commentary presented here is for research purposes only and is not to be taken as investment advice. Readers are expected to perform their own due diligence and/or hire an investment professional prior to entering/exiting positions. Published research ideas are related to the specific market price and publicly available information at the time of research submission/publication. Elle Investments will enter/exit positions without notice.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
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